Cases in financial management stretcher solutions

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MBA 615: Managerial Finance Park University Spring 1 2016

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MBA 615: Managerial Finance (Spring 1 2016) MBA 615

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MBA 615: Managerial Finance (Spring 1 2016)

Table of Contents “Case 8: Fred Alberts, Rookie” by Stretcher, Robert; Michael, Timothy B 1

“Case 12: Working Computers, Inc.” by Stretcher, Robert; Michael, Timothy B

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“Case 13: Automotive Specialties, Inc.” by Stretcher, Robert; Michael, Timothy B

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“Case 14: Gilad Publishing Company” by Stretcher, Robert; Michael, Timothy B

23

“Case 15: Scope City, Incorporated (A)” by Stretcher, Robert; Michael, Timothy B

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“Case 19: McGhee Corporation” by Stretcher, Robert; Michael, Timothy B 35

“Case 20: Labeltech Corporation” by Stretcher, Robert; Michael, Timothy B 39

“Case 22: Sound Advice” by Stretcher, Robert; Michael, Timothy B 45

“Case 26: Haveloche Corporation” by Stretcher, Robert; Michael, Timothy B 53

Bibliography 57

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Case 8

FRED ALBERTS, ROOKIE

FRED'S ACCOUNT

Fred pressed the 'return' key, carrying out the trades he had figured would give him a good return. He had opened the online stock trading account in order to learn about the process of trading and to take advantage of his academic knowledge of how the markets determine stock values. He had taken several finance classes in his undergraduate degree, and had enjoyed learning the way investors decide how much to bid on stocks. Fred figured he could take advantage of this knowledge in creating more wealth than he could if he just invested in an investment fund.

THE BROKER'S ADVICE

When he opened the trading account, Fred had signed up for telephone access to a broker. The account allowed him a certain number of calls and a certain amount of time in consultation with the broker each month. Now, Fred had quite a sum of free cash in the account, money he had transferred from an investment fund that he was not very happy with. The amount he had to invest was about $68,000. He decided to take advantage of the advisement service, and made his first telephone call.

"Welcome to Bettertrade services, Mr. Alberts. My name is Brad Cendron. How can I assist you today?", the voice asked.

"Yes; I would like to get your advice on how to invest a sum of money. My objective is to invest this amount in stocks that appear to be undervalued by the market. Can you recommend about ten stocks that would fit that description?", Fred asked.

"Oh, yes, I'd be happy to. We have listed our top bargains on the "top stock picks" list on the website. Are you online now?", Brad asked.

"Yes, I am," Fred replied. "Oh, I see it here. They are in order, according to your idea of how much of a bargain they are, right?"

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"That's correct, Mr. Albert. We believe that these 20 stocks are going to have greater upside potential over time. I can help you make the transactions, if you'd like."

"Well, I'm going to do a little more research on my own first, but thank you for the link. I'll just carry out transactions via the website, since the transaction fees are lower that way," Fred said.

"OK, Mr. Albert," Brad replied. Let us know if you have other questions, or if we can assist you further."

Fred printed out the list of stocks, and set about the task of collecting information about them. He went to the "market data" link on the company's website to get some information. For each firm, he downloaded the history of dividend payments, and the beta. He also downloaded current treasury bond rates and the rate of return on a broad market index, which he would use as an indicator of the market return. Fred summarized the information and prepared to determine the value of the stocks according to the financial models he had studied in college.

Fred's collection of information and the current market prices of the stocks in the "top stock picks" list from his broker appear in Exhibits 1, 2, and 3.

Exhibit 1. Top 20 Stock Picks List.

Stock Rank 1 2 3 4 5 6 7 8 9

10 11 12 13 14 15 16 17 18 19 20

Price, 1/05/04 $14.89 $29.02 $18.83 $93.48 $67.29 $3.28 $9.00

$55.91 $98.47 $43.07 $37.55 $38.30 $76.33 $67.09

$193.05 $38.33 $71.11 $9.23

$19.35 $29.92

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Case 8 FRED ALBERTS, ROOKIE

Exhibit 2. Dividend Histories and Beta.

Stock Rank Total Dividend, 2003 5-Year Dividend Growth Beta 1 $0.95 0.58% 0.74 2 $0.00 -100.00% 2.3 3 $0.00 0.00% 1.89 4 $1.25 8.50% 1.31 5 $0.78 1.25% 1.52 6 $0.06 -9.00% 1.04 7 $0.00 -100.00% 1.99 8 $0.00 0.00% 0.89 9 $6.22 0.98% 1.06

10 $1.00 -0.48% 1.76 11 $0.00 -100.00% 0.91 12 $0.25 2.10% 1.8 13 $0.98 -2.00% 0.82 14 $2.25 4.00% 1.12 15 $5.80 -8.00% 0.99 16 $1.02 13.00% 1.01 17 $6.00 5.00% 0.67 18 $0.00 0.00% 1.11 19 $1.00 9.00% 0.78 20 $0.00 -100.00% 1.2

*dividend growth is the compound growth rate between Dt-5 and Do

Exhibit 3. Other Financial Information.

Treasury Bond Rate (historical) Return on a Broad Market Index

4.1% 12.1%

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Exhibit 4. Formulas from Fred's Old Textbooks.

Constant Growth Valuation Model:

DI VCS = --=----

keqUity - g

Vcs is the value of the share of common stock DJ is the expected dividend (the last paid dividend times 1 +g) kequity is the required return (Fred would use the CAPM to determine this) g is the growth rate of the dividend

Capital Asset Pricing Model Formula:

kequity is the required return on the common shares kRF is the rate of return on treasury bonds kM is the rate of return on a broad market index f3 is a measure of systematic risk for the company (the 'beta')

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REQUIRED

1. For each stock listed, calculate the required return as indicated by the Capital Asset Pricing Model (CAPM).

2. Calculate the value of each stock share using the constant growth formula.

3. Compare the values you calculated to each of the market prices for the top twenty stock picks. Are your calculations close approximations of the market prices? Why do you think there are differences?

4. What are the implications of your analysis to Fred's choice of stocks?

5. Think about your results in terms of claims of market efficiency. On average, over the long term, do you think that the models you used to calculate the stock values really works? Why or why not?

6. In light of your answer in number 5 above, how would you advise Fred?

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Case 12

WORKING COMPUTERS, INC.

Jennifer Sobieski, an analyst in the headquarters of Working Computers, has been asked to evaluate whether or not Working should sell a division of the firm which has been losing market share and requires a great deal of new investment to remain competitive. The ailing product is a personal data appliance, or PDA, that once led the market in features and innovation, only to fall prey to competition from numerous firms once it had paved the way for the product category. Complicating Jennifer's analysis and recommendation are several political issues involving the wayward division. In particular, Working's recently returned CEO, Stewart Workman, has decided that the product (the Bernoulli device) is a "loser" and has plans to use the capital currently committed to Bernoulli to boost the ailing performance of other parts of the firm.

JENNIFER'S POSITION

In the jobs she worked throughout high school and college, Jennifer Sobieski had never encountered a corporate culture as intense and pervasive as the culture at Working Computers. The corporate motto, displayed on banners, T-shirts and coffee cups throughout the headquarters complex, was "Everyone here really believes in Working." On her long commute home, often after twelve-hour days in the office, she imagined that monks of the Dark Ages had faced a similar environment. Even though she was just a beginner, she could see that becoming part of the company was going to be as challenging to her social and political skills as it was to her technical background. Working Computers had a long history of internal struggle, and it had a loyal user base that had to be kept happy as well.

Jennifer had been hired as a marketing analyst, in accordance with the jobs she had worked during school. After several months, however, it was clear to her superiors that she was far more valuable as someone who could see the future and attach numbers to it. They had decided to promote her to the position of "Cost Engineer," which seemed to have a nice ring to it, and gave her a bigger cubical and more responsibility. Thankfully, the new "office" was also closer to the communal coffee machine. The new position was also more in line

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with her education; she had studied manufacturing technology, finance and industrial engineering in college, and she was putting much of that background to use every day.

Jennifer was struggling with the decision to divest (or perhaps eliminate) a currently profitable product line. Her immediate superior, Tom LaPonte, was the controller and chief financial officer for Working Computers, and had entrusted Jennifer with a super-secret question: could Working do without the Bernoulli division? To be sure, the ultimate decision would be made by LaPonte and the other executives of the firm, including the quixotic and visionary founder and CEO, Stewart Workman. Her task centered on developing the numbers necessary to portray all relevant aspects of the decision. In addition, she had a feeling that this project was one of special interest to the CEO.

WORKING COMPUTERS

Working Computers had been in business for almost thirty years, and it built and distributed a unique line of desktop computers, laptop computers, and an operating system which was preferred by media professionals around the world. In addition to traditional computers, Working had been one of the first companies to market what had come to be known as a "PDA" or personal data appliance. The research and development expenditure for that product line had come at a time when the company was facing stiff competition in the laptop and desktop markets, and millions of dollars had been spent creating a completely new and innovative interface for the Working PDA -- the Bernoulli device. Working's top management, at the time, had felt certain that personal computers were moving in the direction of smaller, more specialized computers which would perform a few tasks more conveniently than a traditional laptop.

THE BERNOULLI DEVICE

The Bernoulli device was a small, handheld device the size of a stenographer's pad with integrated applications for recording appointments, addresses and contact information, as well as freeform text notes. It had been designed to replace the traditional executive calendar binders that Jennifer and so many of her colleagues had carried in school, but it had evolved into much more than that. The Bernoulli had been popular due to the ability of users to write new software for the machines. Users had quickly learned that their investment in the Bernoulli gave them the option to program the machines for almost any task, from electronic reference books to data acquisition from industrial machines. Best of all, the Bernoulli would easily interface with a host computer for uploading and printing. The more recent incarnations of the device had been built for accessing Internet news services and email servers from the field without the need for a full-size laptop or host computer. For reliability, the Bernoulli had no moving parts.

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With success, after a rocky start, came competition. Several different firms had developed PDAs which improved on aspects of the Bernoulli, even though the research and development folks at Working had tried to keep the device current. Most importantly, competitors sold machines which could be connected to a variety of different computing platforms; the Bernoulli device would only upload and download from a Working-brand computer. In addition, even with Working's head start, competitors had used manufacturers outside of the U.S. to lower production costs. To make matters worse, major software developers were beginning to support competing platforms at the expense of the Bernoulli, and that was taking its own toll on market share.

THE PRODIGAL SON RETURNS

Stewart Workman had recently returned to the firm after nearly ten years heading various other successful and unsuccessful companies. When the board of directors ousted him, he targeted his vision and energy towards developing an understanding of the future of computing. Workman had felt that computers could enhance the life of every consumer. He had anticipated the development of the Internet and the World Wide Web, and his interim firms had targeted the academic and research markets with these innovations in mind. In late 2003, however, Working Computers had been in trouble, and the board of directors decided that Workman might have the ability to "save the farm." With that in mind, they offered him the position of CEO and chairman of the board. Workman, already wealthy from his other ventures and his early investment in Working stock, accepted a salary of $10 per year for this role, and the board granted him an incentive plan that awarded stock options according to the growth of the company's stock price. With that type of encouragement, Workman began asserting his desire for innovation and market leadership, and cast a wary eye toward products and services where the firm was less than dominant.

Workman had already let it be known that he would be outsourcing much of the company's production, based on analyses that Sobieski and LaPonte had put together and backed up with hard numbers from Working's overseas partners. Stewart had also made it clear that the firm would take a different direction, one that stressed leadership in innovation and product design. In keeping with this approach, he had mentioned more that once that the Bernoulli device was "behind the times" and a "drain on the rest of the corporation." In fact, in one recent executive meeting which included the head of the Bernoulli division, Workman had referred to Bernoulli as a "black hole of creativity and internal funds." The board of directors had allowed Workman to commission research from LaPonte regarding the viability of Bernoulli as an ongoing product. In Workman's mind it was clear that the funds that currently went to Bernoulli could be put to use rebuilding the company's market share in desktop and laptop computers. Given the depressed state of the firm's stock price, which was at an all-time low, the board was desperate to find ways of regaining the popularity and reputation that the firm had once enjoyed.

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JUST THE FACTS

Jennifer had discretely gathered a great deal of information from the Bernoulli unit as well as several of its competitors. In addition, she had spent the greater part of a week downloading information from the Internet, mainly opinions of the PDA market and the strengths and weaknesses of Bernoulli as an ongoing platform.

Jennifer thought that Bernoulli's declining market share was troublesome. In 2003, Bernoulli unit sales had represented approximately fifteen percent of the market, with the largest competitor grabbing a full 42 percent of unit sales. Unfortunately, market share had been declining at least one percent each quarter, and there was fear that it would drop even more. This drop was likely due to a large competitor's recent announcement that compatibility with its platform, and not the Bernoulli, would be incorporated into a popular line of office software that was unavailable for Working Computers.

The folks in the Bernoulli labs were currently working on major upgrades to the Bernoulli device as well as the Bernoulli interface software; these improvements would make Bernoulli compatible with almost every personal computer on the market. To continue this research, the Bernoulli division estimated that it would need no less than $18 million in the next month in order to finish the development of the more advanced product. Allocating this investment within the division was the responsibility of the division's operating officer, and Jennifer was confident that the money would be put to good use. When the new products became available in late 2004, it was likely that Bernoulli could regain as much as 8 percent of the market within the first year, with gains of four percent per year after that. Nonetheless, in recent meetings, Stewart Workman had criticized the $18 million request as being "insane," stating that he knew of several places in the company where those funds could "earn at least our normal cost of capital for the shareholders." The firm had enough cash available for this type of investment, but Jennifer reasoned that Workman was taking the allocation of that money personally. Jennifer had forecasted unit sales for the periods 2004 through 2009 (Exhibit 1), and she had calculated demand both with and without the additional market share that the new product was expected to generate.

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Case 12 WORKING COMPUTERS, INC.

Exhibit 1.

Working Computers Unit Sales Projections Periods ending December 31, 2003 through December 31, 2009 (units, in thousands)

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12/31/03 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08 12/31/09 Units Sold, with new investment

Units Sold, without new investment

180,000 150,000

180,000 150,000

189,000 246,000 264,000 264,000 264,000

102,000 57,000 48,000 48,000 48,000

Currently, the Bernoulli division operated with a cost of goods sold of approximately sixty percent of the unit price and operating expenses (excluding depreciation) averaging 24 percent of total revenues. The division expected to sell a total of 300,000 units by the end of 2003 at a price of $495 each. The model expected to ship beginning in late 2004 would sell at the same price point. The division's managers estimated, though, that the revised Bernoulli would have a cost of goods sold of 54 percent of the retail price with higher operating expenses of 26 percent due to increased advertising. Given the competitive nature of the industry, this price point and cost estimate were expected to remain the same for the next several years.

For strategic planning purposes, Working's management allocated depreciation to the existing Bernoulli division as though the entire division was an asset in the modified accelerated cost recovery (MACRS) 10-year class, with five years of operation behind it. The initial investment of $56 million had been made in early 1999. Recovery allowance percentages according to MACRS are shown in Exhibit 2. The new funds allocated to the division would be treated similarly, except that management had decided that any new investment would be depreciated using the MACRS category for 5-year assets; due to changes in the industry since 1999, this was expected to be more consistent with the nature of the market for computing devices and PDAs. Working's managers used a weighted average cost of capital, or hurdle rate, of 14.5 percent when evaluating capital budgeting projects, and Jennifer felt that this would be an appropriate discount rate in this instance as well. The firm's marginal tax rate, for planning purposes, was 34 percent.

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Finally, Jennifer had to consider the fact that the company always held the option to sell the Bernoulli division to an existing competitor. In fact, there were rumors on the Internet that several quiet and unofficial offers had already been discussed with the members of the board of directors. In developing her analysis, Jennifer would have to come up with an estimate of. a price for the division, based on the sales and market share expectations she had gathered. To establish a terminal value in the final forecast year, 2009, she would capitalize the cash flows in that year by dividing them by Working's overall cost of capital, essentially treating that year's cash flow as the payment from a perpetuity. In the event that management declined to invest the requested $18 million today, the Bernoulli division could still maintain some level of sales for several years, and the patents held by the division would be worth selling or licensing as well.

Exhibit 2. Modified Accelerated Cost Recovery (MACRS) Allowance Percentages

Ownership Year

1 2 3 4 5 6 7 8 9 10 11

5-year assets

20% 32% 19% 120/0 11% 6%

10-year assets

10% 18% 14% 12% 9% 7% 7% 7% 7% 6% 3%

For her previous presentations to senior management, Jennifer had produced detailed discounted cash flow analyses accompanied by documents to support her assumptions. In addition, she usually spent some time developing sensitivity analyses using any numbers that she expected to be questioned by the board. This time, her main fear was that her understanding of the growth in market share, because of the revised Bernoulli due in late 2004, would turn out to be optimistic.

After reviewing her notes, Jennifer grabbed her gym bag and headed off to the fitness center in the next building. She anticipated having a long night ahead of her, and a jog and a shower was just the thing to clear her head and help her focus. Once in the lobby of her building, she passed under several hanging banners promoting the company's newest

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Case 12 WORKING COMPUTERS. INC. 89

products, bearing slogans such as "Imagine Working" and "We're Working For You." Another read "We're Always Working" in the corporation's trademarked font. Reading this banner, Jennifer slowed and said to herself, "Isn't that the truth."

REQUIRED

1. Given the unit sales information in Exhibit 1, develop an annual revenue forecast for 2004 through 2009. Forecast sales first assuming that the revised Bernoulli will be introduced one year from today, and then create a forecast which is based on sales of the current model, assuming that Working declines to invest more capital in Bernoulli.

2. Use the cost information Jennifer has assembled to construct a forecast of cost of goods sold and operating expenses for 2004 through 2009. Assume first that the Bernoulli will be introduced, with its new cost structure, one year from now, and then calculate a cost forecast assuming that the $18 million is not provided for development of the new product.

3. Using the information developed for Questions 1 and 2, develop a discounted cash flow analysis for the Bernoulli division for 2004 through 2009. Working's board has asked for net present value and internal rate of the return when making decisions in the past. Complete your analysis assuming that the additional investment is contributed today. Be sure to recognize a terminal value for the division at the end of 2009.

4. Make a recommendation as to whether or not Working Computers should contribute the requested $18 million to the Bernoulli. Be sure to recognize all aspects of the decision, including the potential impact that the requested ongoing investment dollars could have on the plans of Stewart Workman.

5. Jennifer expects Stewart Workman to ask about selling the Bernoulli division. What price should Working ask for if it sells Bernoulli today, immediately after making the requested investment? What price could it expect to receive if it plans to leave Bernoulli alone?

6. In addition to the issues in Questions 1 through 5, what other considerations might be appropriate when a firm is considering eliminating a product line or divesting a division?

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Case 13

AUTOMOTIVE SPECIALTIES, INCORPORATED

Automotive Specialties, Incorporated (ASI) is a domestic division of a multinational holding company, and it has been invited by its largest customer (also a large multinational firm) to build a new plant in the small South American country of Mesa Verde. Jamie Miles, assistant treasurer of ASI, has reviewed the customer's proposal and she has developed several analyses and forecasts of her own to supplement that information. Although most of the uncertainty of foreign investment will be handled through the liason with ASI's customer, Fujimora Transport, the value of the investment hasn't yet been determined. In addition, the customer may have motives that the management of ASI will need to consider before committing funds to such an ambitious project.

INTRODUCTION

With so many deadlines and fires to fight, Jamie Miles saw no end to her day. She had grown to love her job, and especially the title of "Assistant Treasurer", but no amount of amour or prestige could smooth over the eyestrain or hasty lunches in the company canteen. In obtaining the title of Assistant Treasurer, and the fancy business cards that came with it, Jamie had worked ninety-hour weeks for as long as she could remember. Holidays were just something noted on a calendar; they were days when she could work uninterrupted by phone calls. She could remember her last year of school, and how things had seemed so tough then. After a six-month job search, endless interviews, and a year on the job, the last couple of semesters' of work toward her finance degree seemed to have been another life entirely. She had no doubt that the next few weeks would be more intense, yet, as she helped prepare the capital budget for the upcoming year.

Most of the projects that crossed her desk were routine replacements of existing equipment or expansions of product lines into new markets. The project that was giving her the most trouble, this week, involved the decision to enter into an agreement to open a plant offshore. One of her best customers, Fujimora Transport, operated several assembly plants in South America. Fujimora had proposed that Automotive Specialties build a new plant adjacent to one of the Fujimora facilities in an effort to streamline inventory management and reduce costs. In fact, the proposal from Fujimora guaranteed funding of the operation at a reasonable cost of capital, promised to secure the legal (and political) arrangements, and

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included compensation for training and personnel services for local workers who would be hired to operate the machines at the new plant. In addition, Fujimora had agreed that the facility should have a large enough capacity to allow Automotive Specialties to not only meet the current and future needs of Fujimora, but also to allow the company to expand its customer base in the region. Automotive Specialties' board of directors had agreed to fund a site survey and had commissioned Jamie to investigate the proposition prior to making a final commitment.

AUTOMOTIVE SPECIAL TIES

Automotive Specialties, Incorporated (ASI) had existed in one form or another since the 1930s. It was a division of a larger firm, Stevens-Simper, Incorporated. Stevens-Simper had been around almost as long, and currently had operations in twelve other countries, with products and services ranging from automotive parts (with ASI) to underwater salvage and recovery. ASI was a small part of the conglomerate, and it was allowed to pursue opportunities each year and develop markets as its managers saw fit. The parent firm helped with raising capital and set targets for shareholder returns, but it left ASI to make most investment decisions independently. In fact, Jamie often used her counterparts in the "home office" as unofficial audiences for upcoming proposals for ASI's board, and the Stevens- Simper treasurer's office had provided a great deal of wisdom and expertise on many occaslons.

ASI "specialized" in powdered metal fabrication. The firm mixed various types of metals in powdered form, pressed this powder into engine components, and then used skilled machine operators to finish the products into completed units. ASl's advantage was a patented process for pressing and sintering the products. In most cases, the resulting gears or cams would have little need for costly finishing labor. Because ASI refused to license this technology, the firm enjoyed a lower cost of production than most of its competitors. In addition, ASI products were often of much higher quality than the next best alternative. Given the company's research and expertise in the area, and the continuing refinements being made to the process, it was expected to continue this lead under its patent protection for the next five to eight years, at a minimum.

Fujimora had relied on ASI products for the past ten years, and sales to Fujimora represented almost 40 percent of ASl's annual revenue. ASI components were used in Fuj imora products around the world, and ASI continually won praise and production bonuses from the firm. Many of the ASI executives and production staff had traveled to Japan to train and enjoy the hospitality of their best customer, and the relationship continued to develop as successive quarters of record output and quality went by. To be sure, ASI would continue to be a major supplier of components to Fujimora regardless of the decision to expand the smaller firm's facilities overseas.

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MESA VERDE

The new plant was to be built in Mesa Verde, a small country located on the west coast of South America. Although many of its neighbors had experienced turbulent political situations in the recent past, Mesa Verde had been lucky. The country was a representative republic, with many of its laws and customs influenced by its trade with the US and Britain over the past thirty years. The current president had been in power for several years, and the country had enjoyed the right to elect its government for almost two generations. Due to its geographic isolation, the mountainous country had avoided conflicts with neighboring states as well. The resulting stability had allowed Mesa Verde to develop the infrastructure and human capital to support many diverse industries. In addition, Mesa Verde's diplomatic relationships with the developing markets of Brazil and Argentina provided opportunities for local firms to compete and reinvest their earnings in their homeland. Mesa Verde wasn't a perfect location, but it was one of the safest places that ASI could invest overseas. With Fujimora's backing and reputation in Mesa Verde, Jamie felt that ASI was being given a terrific opportunity.

ASI - MESA VERDE

The proposed plant would produce powdered metal products, initially, to meet the demand of the Fujimora plant in Mesa Verde. Currently, the Fujimora plant there ordered approximately ten percent of its purchases from ASI's domestic operation, with the remaining needs of the plant being met by small local shops or other offshore facilities. The Fujimora proposal was based on hiring and training many of the firm's local suppliers for work at the new ASI operation. Jamie had reviewed the expected demand quantities in the proposal and developed her own estimates of unit demand at the Mesa Verde plant (Exhibit 1). In the table, Jamie listed the expected Fujimora demand for each product as "Mesa Verde" and eventual sales to other firms and/or markets as "other markets."

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Exhibit 1. Expected Demand for Powdered Metal Products ASI - Mesa Verde Plant (annual units, in thousands)

Product 2006 2007 2008 2009 2010 2011

SKU 517 Mesa Verde 155.10 160.60 167.00 173.70 181.07 189.18 other markets 43.43 45.27 47.30

SKU 453 Mesa Verde 172.51 179.76 187.74 196.51 206.16 216.78 other markets 49.13 51.54 54.93

SKU 367a Mesa Verde 121.55 125.78 129.65 134.10 139.22 145.10 other markets 44.70 46.41 48.37

After reviewing the domestic cost estimates, Jamie thought that the current cost of goods sold allowance for each Mesa Verde product was close to the projected cost at the new plant, but she decided that she would need to lower the cost of labor factored into each. Currently, the cost of producing SKU 517, domestically, was approximately 67 percent of its unit selling price; in Mesa Verde, this would likely be lowered by twenty percent, to approximately 53.6 percent of the selling price. For SKU 453 and SKU 367a, the reduction would be similar, but these products had domestic costs of goods sold of 70 percent and 62 percent, respectively. In addition to reductions in cost, though, the firm would have to lower unit prices to accomodate Fujimora's wishes, and Jamie had compiled a listing of revised prices (adjusted for local inflation) in order to get an estimate of revenues for the proposed plant (Exhibit 2). Her numbers were based on her own research regarding the Mesa Verde economy, current and historical exchange rate trends, and the political history of monetary policy in the small country. The official currency of Mesa Verde was the royale, and it had enjoyed remarkable stability against the U.S. dollar in recent years. Because the Mesa Verde operation would be trading with other currencies which were not as strong, Jamie estimated prices for exports in royales as well.

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Exhibit 2. Expected Unit Prices for Powdered Metal Products ASI - Mesa Verde Plant

Product 2006 2007 2008 2009 2010 2011

SKU517 U.S. price $10.75 $11.13 $11.52 $11.92 $12.34 $12.77 Mesa Verde R860 R868.14 R875.52 R882.08 R888.48 R893.90

SKU 453 U.S. price $11.17 $11.67 $12.20 $12.75 $13.32 $13.92 Mesa Verde R893.60 R910.26 R927.20 R943.50 R959.04 R974.40

SKU 367a U.S. price $20.67 $21.39 $22.14 $22.92 $23.72 $24.55 Mesa Verde Rl,653.60 R1668.42 R1682.64 R1695.08 R1707.84 R1718.50

Current estimates of operating expenses were approximately ten percent of per-unit prices, domestically, and this was expected to increase to sixteen percent in Mesa Verde in the first two years of the new plant's operation. Jamie expected operating costs to decrease by 2007 to an estimated 13.5 percent of unit price, and the Fujimora estimates agreed with this, more or less.

According to both the Fujimora proposal and the engineer's report on her desk, the plant would cost approximately $11.6 million to build (beginning immediately), and it could be in operation at the end of the next calendar year (2005). It would require an additional working capital outlay of approximately $1.2 million, which wouldn't be needed until the start of operations in early 2006. The engineer's report and site survey had already cost the finn $100,000 in the prior quarter.

Even though Fujimora had agreed to secure financing for the project, Jamie's contacts at Stevens-Simper had suggested that she use the allocated weighted-average cost of capital that ASI used for domestic projects when discounting the Mesa Verde proposal. Currently, that hurdle rate was set at 10.95 percent. Jamie had considered adjusting the hurdle rate for the extra risk inherent when investing in emerging markets, but her advisors warned against this, suggesting that she apply any risk adjustments to the cash flows instead. Depending upon her assessment of the political risk of the investment, Jamie knew that she could always adjust each annual cash flow (after taxes) downward by some amount. Due to the safe economic and political environment of Mesa Verde, Jamie didn't plan on adjusting cash flows for political risk. In addition, she had already adjusted her demand estimates for uncertainty.

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Her advisors also suggested that any risk stemming from expected fluctuations in the overall economy and exchange rates should be incorporated into Jamie's projection of exchange rates. Jamie planned to address this type of risk by completing analyses of several different scenarios which would illustrate the uncertainty of the cash flows from the Mesa Verde project due to a weakening royale. As for her sales estimates, Jamie felt certain that Fujimora would stand ready to purchase the necessary units of each SKU from domestic production in the event that the Mesa Verde operation proved untenable. After all, this plant had been Fujimora's idea in the first place!

One of Jamie's friends at the "home office" had suggested, quietly, that Fujimora would offer to purchase the ASI operation at the end of Jamie's planning horizon of six years. Most likely, the firm could negotiate with Fujimora to obtain a fair price, or one which would at least cover ASI's investment in the plant. Jamie would calculate a "terminal value" for the plant in 2011 based upon treating the annual cash flow in that year as a perpetuity. To value that cash flow stream, she had decided to use the firm's cost of capital as a rough approximation of the required return on such a perpetuity. Because the project will be sold as a complete operation in the final year, the working capital contribution would not be recovered in the final period. In addition, the revenues earned in Mesa Verde would be subject to the local marginal tax rate of 45 percent, and ASI could depreciate the initial investment over the six year period using the straight-line method approved for corporations in Mesa Verde. Under the current U.S. tax code and several treaties, profits from Mesa Verde wouldn't be subjected to additional corporate taxes once they were brought back into the country by ASI.

By the time Jamie had reviewed this information and summarized her notes for the board, it would be well past her normal lunch hour. She stood and walked to the office door, opening it and noticing her name and title stenciled on the frosted glass. As she headed to the canteen, yet again, she thought about the Mesa Verde plant and wondered when she would get to see it for herself. How often did assistant treasurers get to go on fact-finding missions?

REQUIRED

1. Using the demand and price estimates in Exhibits 1 and 2, develop annual revenue projections for the Mesa Verde project.

2. Using the information in the case, develop estimates of the cost of goods sold for each SKU, operating costs, and depreciation expense for the Mesa Verde plant for each of the next SIX years.

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3. According to the budgeted figures calculated for Questions 1 and 2, produce a discounted cash flow analysis for the Mesa Verde project. Include estimates of the project's net present value and internal rate of return. Express the annual cash flows and net present value in dollars, according to Jamie's estimate of the royale-to-dollar exchange rate. (According to the numbers in Exhibit 2, the estimated exchange rate today and in 2006 will be R80 per dollar, and this is expected to appreciate by R2 each year afterwards.) Should ASI accept the project?

4. Jamie's initial estimates assume that the royale will strengthen over the next several years. Reproduce the analysis asked for in Questions 1 through 3 to reflect the possibility that the royale will weaken (by R2 per year) against the dollar over the project's planning horizon. Should the new plant be built?

5. Jamie consulted several economists and the World Wide Web and found that the chance of the royale weakening (in the manner described in Question 4) is approximately 38 percent. Calculate the project's expected net present value and internal rate of return using this additional information. How should this impact Jamie's recommendation?

6. What other considerations should ASI make when deciding upon the Mesa Verde investment?

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Case 14

GILAD PUBLISHING COMPANY

Annette Gilad, general manager of Gilad Publishing Company (GPC), is faced with a decision point in the life of the company. Recently, an expansion in GPC publications has necessitated the purchase of new equipment and perhaps the addition of new personnel. Annette's decisions will significantly impact the risk and profitability prospects for GPC's future.

BACKGROUND

Gilad Publishing Company (GPC) is a small publisher located in Memphis, Tennessee. GPC serves a growing market for publishing soft and hard-bound books and periodicals. GPC mainly serves the market for specialty educational books, small-run company publications (such as catalogs), and books that are not expected to sell large quantities in bookstores (called "specialties"). The firm has the reputation of being a small company that has achieved competitiveness in both the pricing of specific jobs and in the effective marketing of specialty publications. The company has limited its publishing to physical book production and marketing. The virtual (electronic) publishing arena appears to be beyond GPC's capabilities and is not an area involving their competitive advantages. GPC also has avoided trying to compete with large publishers because of pricing disadvantages and higher per-unit costs. Fortunately, these large publishers are not particularly interested in smaller jobs that GPC can easily handle.

GPC deals with customers in two distinct ways. For 'custom publishing' customers desiring to either market their product themselves or who seek GPC's services for printing and bookbinding, the firm will submit bids based on cost coverage plus an acceptable markup. Other customers approach GPC for the purpose of manuscript evaluation, and upon acceptance, marketing of their works (acquisitions). The manner with which GPC deals with each scenario is very different.

Lewis Alcorn is associate manager in charge of the acquisitions division. He decides which manuscripts are worthy of publication and marketing, and oversees the process from selection to delivery (to book retailers). Lewis considers himself an 'underwriter' of sorts since the company takes the risk (concerning future sales) resulting from his decisions about

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manuscript submissions. Lewis considers a book that meets or exceeds sales expectations a 'winner' and ones that fail to meet these expectations 'losers.' This is almost always a self- fulfilling prophecy, since Lewis's pricing methodology is based on expected product sales.

Tammy Lange manages GPC's other division, custom publishing. Tammy deals with customers desiring to have their own work published and sometimes marketed. Custom publishing differs from acquisitions in that the custom publishing customer bears the initial or the entire cost of production. Under this arrangement, GPC incurs little risk, since payment is received in advance. There exists the possibility for incremental income, though, from a markup on all units sold beyond an established minimum paid for by the customer.

COST STRUCTURE DECISIONS

GPC's general manager, Annette Gilad, started the company in 1991. She has taken the firm from its infancy with only four acquired titles and ten custom publishing accounts to its current levels. The firm now has 830 titles and 2,390 active custom publishing customers. With its initial purchase of equipment in 1991, only marginal investment in additional equipment has occurred in the past eleven years. Now Annette faces a relatively severe need for additional capacity; a situation calling for considerable fundraising. GPC has had to 'farm out' some of its projects to bookbinding services in the area, simply because lengthier production runs tended to outstrip GPC's production capacity. This had adversely affected GPC's profit margin, which was traditionally in the 10-15% range, but had shrunk to about 3%, since some of the farmed out projects had higher costs than GPC could recover with revenues. These larger jobs were becoming too numerous, and the profit potential was negative if the work was contracted with other bookbinding services. This convinced Annette that a larger, modem production facility would solve these issues.

GPC is a private corporation, and is closely held by the Gilad family in Memphis. Annette has already found another investor willing to assume a minority shareholder position, holding 20% of the firm's stock. To make the stock attractive to the new shareholder, the Gilad family shareholders all agreed to forego dividend receipts on their shares for two years. The new shareholder also agreed to receive dividends as 30% of positive net income, relieving GPC of the burden of dividend expense if earnings were low or negative. The new investor will receive 200,000 shares of GPC stock for a price of $60 per share. GPC will receive $12 million from the sale, less a 1 % fee for legal and other related costs. The new shareholder agreed to reduce the total amount to be invested if Annette decided that less was necessary. One condition, however, was that at least 100,000 shares would be available at the $60 price. Annette's only alternative to raising between $6 and $12 million in equity was not to raise equity funds at all. This would cause the entire amount of any expansion to be financed with debt.

Although the investor seemed inflexible, Annette was willing to bend, because she had experienced difficulty finding an equity investor at all, given the fact that the investor would basically be a minority shareholder in a family owned corporation. She realized that

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this was not a very attractive position for an equity investor. The fact that someone was willing, even with the constraints, was unusual.

Annette has secured a letter of intent from a large bank in the area for up to $3 million. The equipment would involve an equipment mortgage on all of the new equipment purchased, not just the portion purchased directly with borrowed funds. A lower interest rate could be obtained on the loan if the value of the pledged assets exceeds the balance on the loan by a wide margin. The equipment will be fully depreciated by the end of the tenth year, although estimates of useful productive life are almost 20 years. Payments would be monthly on the ten-year loan, and the bank has offered a competitive 8.75% fixed rate of interest.

The bank requires that GPC specify the portion of the approved financing they need by the end of the current month. In order to specify a borrowing need for the fixed assets involved in the expansion, Annette needs to decide on one of the possible operational/financing alternatives, outlined below. In the event that GPC needs more funding than provided by the bank for the expansion, the additional amount will have to be raised.

OPERA TIONAL ALTERNATIVES

Two proposals have been forwarded by GPC's cost accountant as alternative ways of structuring operations. They each involve differing levels of investment in fixed assets, and thus differing levels of other productive inputs. Annette asked that all operating expenses be identified as fixed or variable (with respect to sales levels). A summary of costs under each of the three proposals appears in Exhibit 1.

Exhibit 1: Operational Alternatives.

FULL EXPANSION ($16,000,000 investment infixed assets)

Additional Annual Revenues and Operating Costs:

Revenues Fixed Cost Variable Cost

$21,600,000 $4,000,000 $200,000

PARTIAL EXPANSION (B) ($8,000,000 investment infixed assets)

Additional Annual Revenues and Operating Costs:

Revenues Fixed Cost Variable Cost

$9,800,000 $2,048,000 $ 156,000

*Direct Costs are assumed to remain at the same percent of sales **Tax rate is a constant 32% ***Depreciation is straight line with a ten year asset life, and is included in fixed costs.

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Exhibit 2: Income Statement for the year ended December 31, 2003.

Net Sales (Titles) Net Sales (Custom Publishing)

Total Net Sales

Expenses:

Direct Materials Cost (Titles) Direct Materials Cost (Custom Publishing)

Total Direct Materials Cost

Variable Operating Costs Total Fixed Costs

Total Operating Cost

Earnings Before Interest and Taxes

Interest Expense Tax Expense NET INCOME

$16,600,000.00 4,790,000.00

-8,843,000.00 -4,124,000.00

-6,320,000.00 -1,006,000.00

-102,000.00 -372,980.00

21,390,000.00

-12,967,000.00

-7,326,000.00

1,097,000.00

$622,020.00

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Exhibit 3: Balance Sheet. December 31, 2003.

Current Assets: Cash and Equivalents Accounts Receivable Inventory Prepaid Items

Total Current Assets

Fixed Assets

TOTAL ASSETS

Liabilities: Accounts Payable Short-Term Loan Bonds Payable

Total Liabillities

Equity: Common Stock Retained Earnings

Total Equity

TOTAL LIABILITIES + EQUITY

$91,000.00

818,000.00

3,301,000.00 109,000.00

$898,000.00

12,000.00 1,000,000.00

2,000,000.00 4,511,000.00

105

4,319,000.00

4,102,000.00

$8,421,000.00

1,910,000.00

6,511,000.00

$8,421,000.00

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REQUIRED

1. Which of the firm's divisions is more risky, and why? In terms of size, comment on each of the expansion plans. Would a creditor be concerned? Why?

2. Estimate income statements for 2003 for each of the two expansion scenarios. Assume that Annette wants to minimize the amount invested by the equity investor, preferring to use debt for financing as much as she can. Remember to consider the investor's requirements.

3. Estimate the 2004 DOL, DFL, and DeL for the firm, for each expansion. Does it appear from the resulting earnings that it is advisable for ope to favor high leverage?

4. What are the implications of higher depreciation concerning 1) cashflow and 2) fixed charge coverage?

5. Now assume that Annette will maximize use of common stock financing for all expansions, up to the limits that the new investor has asserted. How does this change your answer in number 3 ? (consider that common stock has a flexible cash payment, and that it typically involves a higher required return by investors)

6. What is the implication of stockholders giving up current income?

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Case 15

SCOPE CITY, INCORPORATED (A)

There was little time in Ruby Damodaran's day for casual chatting, but every time her boss came by she made the time. The CFO of Scope City, Tom Dillon, was her boss but he was also a great storyteller and a terrific source of information about the industry in which she had chosen to work.

Scope City, Incorporated (SCI) was a manufacturer, reseller and importer of advanced optical equipment, including consumer (amateur) telescopes, nautical optics, and accessories. Over the past thirty years the firm had grown from a small repair shop in east Texas to a regional leader in quality optical products. SCI's retail and catalog operations were known for friendly service and quick turnaround, and the firm's ability to repair even the most obscure instruments made them somewhat unique. After an initial public offering several years before, Scope City'S shares traded regionally, and benefited from the company's reputation with its customers. Although the firm was still considered to be closely-held by most analysts, several national investment houses had begun to monitor the stock and tout the shares to institutional clients.

Tom Dillon was busy preparing Ruby to help him outline Scope City'S prospects to potential shareholders at a regional "investors' conference" in a few weeks. Over three days, Scope City's team would have a chance to offer a presentation for institutional investors, first in a general setting with other small firms and then in individual sessions with specific investors, advisors and analysts. Tom's casual information sessions with Ruby were designed to build her background knowledge of the company and industry as rapidly as possible.

THANK YOU COMET HALLEY

As many folks in the telescope industry conceded, most consumers only became interested in watching the sky when there was some special event taking place. In the 1980s, the return of Comet Halley had been such an event. Amateur telescopes were sold in tremendous numbers in order to allow people to observe the great comet from their backyards, and media attention on the event prompted schools and universities to reopen visiting hours at observatories and promote scientific endeavors directly to the public. For

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Scope City, struggling as a repair shop and res eller, it had been a great opportunity to grow, and Dillon and the other founders had spent more of their time running the business than looking skyward.

The several years immediately following the comet craze had proven to be lean ones for many optics firms, but Scope City's diverse customer base had given it a great advantage over its competitors. Even today, SCI had enough repair and wholesale business to allow it to remain profitable throughout the year, and it had a reputation sufficient to give it an advantage when the Christmas retail season arrived. In addition, SCI was the sole U.S. importer for several different optics manufacturers in Taiwan and Japan.

Each month SCI held free seminars at its stores to educate consumers on the value of quality optics and tried to help customers avoid the temptation to buy cheaper, mass- produced "department store" telescopes and binoculars. Although such telescopes were fairly common (and inexpensive) during the last few months of the year, most serious amateurs agreed that someone new to the hobby could easily be discouraged if the newcomer's introduction to the night sky was marred by an instrument of poor quality and workmanship. For the store staff, it was also a frustrating occasion when customers came in for help after spending several hundred dollars elsewhere -- there was only so much one could do to fix a poor design. The SCI staff and management felt that education was the best method for building their customer base, and these efforts had been repaid over time. SCI had also been a pioneer in using the Internet to provide information to consumers. The firm's free publication "A Beginner's Guide to Skywatching" was very popular at astronomy clubs and star parties around the country.

FINANCING THE STARS

As a recent finance graduate, Ruby Damodaran was new to the company, and she welcomed Dillon's insight and history lessons. It was imperative that she learn as much about SCI as possible before meeting with investors. Even though she didn't plan to spend much time at the podium, she knew that the success of SCI's presentation depended upon everyone on the team. She also knew that part of her role as assistant controller would be to make presentations of this type throughout the year and to be able to discuss the prospects of the firm when necessary. These days she was definitely in "study mode."

Ruby was currently struggling to get her conference agenda prepared, and also to make constructive comments about the material prepared by Dillon. One task that remained before the investors' conference was to examine the firm's current and expected growth and capital structure. She knew that Dillon and the other members of the board of directors didn't consider capital structure to be an important issue, but their discussions about the upcoming investors' conference had highlighted the need for new capital and innovative financing for

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future projects and potential acquisitions. In order to understand the need for any future financing, Ruby felt that she would need to understand the firm's capital up to this point. She had compiled the most recent balance sheet (Exhibit 1) and revenue figures (Exhibit 2), and collected some information regarding other aspects of the financing decision (Exhibit 3).

Exhibit 1. Scope City, Incorporated Balance Sheet. December 31,2003. (dollars, in thousands)

Current Assets

Fixed Assets

Total Assets

Current Liabilities

Long-Term Debt

Common Stock ($2 par value)

Retained Earnings

Total Liab. & Equity

$5,625

$5,625

$11,250

$1,500

$2,250

$1,500

$6,000

$11,250

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Exhibit 2. Scope City, Incorporated. Revenue and Earnings.

Year Sales Net Income 1994 $7,500,000 $900,000

1995 $10,312,500 $1,267,500

1996 $12,000,000 $1,440,000

1997 $18,750,000 $2,156,250

1998 $21,375,000 $2,250,000

1999 $23,250,000 $2,673,750

2000 $27,375,000 $3,011,250

2001 $31,875,000 $3,225,000

2002 $34,125,000 $3,375,000

2003 $38,625,000 $3,422,700

Exhibit 3. Selected Capital Market, Firm & Industry Data.

Yield on AAA corporate debt

Yield on 10-year U.S. Treasury bonds

Historical average return on a broad market average of common stock

Dividend payout ratio (average) for competitors in retail optics and repair

Marginal tax rate for SCI (recent)

Coupon rate, SCI's outstanding long-term debt

Remaining term to maturity, SCI's outstanding long-term debt

Dividend payout ratio, SCI (recent)

Market price per share, SCI (recent)

EPS $1.20 $1.69 $1.92 $2.88 $3.00 $3.57 $4.02 $4.30 $4.50 $4.56

6%

5.10%

16%

25%

300/0

7.50%

6 years

32%

$18.00

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SCI had recently been approached by the parent company of one of its smaller competitors, a specialized telescope manufacturing firm. It seemed that the directors of the parent firm, a holding company, were tired of trying to understand the telescope business and were ready to divest. Although these talks were going on in strict secrecy, SCI had participated in similar spin-offs in the past, and it was reasonable to include alternatives such as this one in the firm's plans for the future. The board of SCI didn't yet have a clear understanding of how or when this potential acquisition might take place, but they understood it's potential significance for the future of the company.

Ruby was concerned that institutional investors would want to know about the firm's alternatives and costs when determining its potential for growth. Ruby could remember from her finance classes that the firm's costs of capital were important considerations, but she had yet to take the time to put everything together. As the conference date approached, she also wanted to take some time to observe the heavens through several different SCI telescopes before leaving on her trip, in order to become more familiar with the products. "Perhaps after work tonight," she thought. After all, early morning was always a good time to go outside with a telescope.

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REQUIRED

1. Describe the company's core business and the markets that it serves.

2. What are the compound average annual rates of growth for SCI's revenue and net income? How should the firm (eventually) analyze the value of the potential acquisition in light of these numbers?

3. What is SCI's historical (book) cost of equity?

4. What is SCI's historical (book) cost of long-term debt?

5. How do the firm's current liabilities influence the cost of capital calculation?

6. Using your answers for 3, 4 and 5 above, determine SCI's historical weighted-average cost of capital (WACC).

7. How should the presentation for the investors' conference discuss the firm's growth and historical cost of capital? How are historical costs relevant when discussing future investment?

8. What other information should Ruby Damodaran have on hand for her presentation to the conference? Additionally, what types of questions will investors likely ask of SCI? How will new types of investors (institutions, for example) likely impact SCI's choices of capital and strategy in the future?

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Case 19

MCGHEE CORPORATION

For as long as he could remember, Calvin McGhee had enjoyed long car trips. As a child he had spent summers travelling with his family, by car, to most parts of the United States. To him, road trips were the most fun one could have, especially if you could stop along the way and enjoy the sights.

Not surprisingly, Calvin became a long-haul trucker after college. It paid good wages and had the advantage of allowing him to see the country from the cab of his truck. He couldn't do any sightseeing this way, of course, but he figured that there was always time for that later.

Six years of open road trucking took its toll, however, and Calvin was tired of the long hours and poor working conditions. As he became more and more discontent with the trucking industry, he started to look for ways to use his knowledge to start a business of his own. Calvin founded McGhee Corporation in the late 1980s.

McGhee specialized in "jobber" sales at truck stops and travel centers across the U. S. and Canada. "Rack jobbers" came in and stocked one part of the store, maintaining inventory and keeping track of consumer interests and popular products. In many cases, these items were the only shopping opportunity that truckers had during the week. Calvin had been able to start small by capitalizing on his knowledge of the trucker lifestyle and the needs of those on the road. Initially, he contracted for shelf space at truck stops in his region and filled that space with wholesale goods he found at closeout sales and business auctions. Truckers had responded by snapping up the toys, books and small appliances that Calvin thought would be appreciated. Within two years Calvin had hired a dozen other employees to help with his routes, and after another two years he needed dozens more. In addition, he had found ways to buy imported goods and keep his inventory consistent across the country.

GET YOUR MOTOR RUNNING

By the end of 2003, McGhee Corporation had become one of the largest jobbers in the U.S. The firm sponsored many products for import, with its own brand names, and had successfully offered Internet ordering only a year before. The company sold everything from video games and textbooks to laptop computers online and maintained job racks and gift

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sections in thousands of locations across the country. Finally, Calvin McGhee thought he would be able to take the time to travel and be a tourist again.

In order for Calvin to do this, however, it was necessary for him to spend less and less time in the office. To this end, he had spent time the previous year hiring and training a new assistant and teaching her the intricacies of the rack jobber business. Sheryl Plath was just a few months out of school and trying as hard as she could to learn everything about McGhee and his business. Mr. McGhee had placed a great deal of faith in her, and it was obvious that he planned to put at least part of the future of his company in her hands.

THE CASH-TO-CASH CYCLE

Calvin had challenged Ms. Plath using a series of exercises involving the firm's accounting numbers. This week, the lesson was in the area of "working capital management." In addition to her regular tasks, Sheryl was expected to work on this problem and present her findings to Mr. McGhee at the end of the week. Calvin had prepared a balance sheet (Exhibit 1) and some additional information about the firm's cost structure (Exhibit 2). Both statements were based upon 365 days in the firm's fiscal year.

Exhibit 1. McGhee Corporation. Balance Sheet, December 31,2003.

Cash Accounts receivable Inventory Current assets

Net fixed assets Total assets

Accounts payable Accruals Notes payable - bank Current maturities of L T Debt Current liabilities

Long-term debt

Common stock & PIC Retained earnings T otalliabilities & equity

$140,000 $1,225,000

$875,000 $2,240,000

$2,135,000 $4,375,000

$700,000 $140,000 $788,000

$87,500 $1,715,000

$962,500

$297,000 $1,400,000 $4,375,000

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Exhibit 2. Selected Income Statement Information, December 31, 2003.

Sales Revenue, net Cost of Goods Sold, net Purchases, net Operating expenses

$15,968,750 $10,675,000 $11,252,500 $4,462,500

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The current lesson was about the firm's "cash-to-cash" cycles. Calvin stressed that working through the difference between the cash-to-cash cycle for assets and the cycle for liabilities could help Sheryl understand the need for short-term borrowing. "We can only get so much credit from our suppliers," he reminded her. He gave her an outline of the process and its importance (Exhibit 3).

As he left for another road trip, Calvin smiled and reminded Sheryl that "every minute you spend with this finance stuff now is twenty minutes saved later on." He would be back on Friday afternoon, and they could talk about the firm's working capital then.

Exhibit 3. Memo Regarding Firm's Cash Cycle: 12/31/03.

Sheryl:

The usual thing to worry about is the difference between assets and liabilities. If assets convert to cash faster than liabilities, that's a good thing, but that's a very unusual situation. More often, your liabilities will be "due," essentially, before your receivables have come in fully. Cash sales, when they actually happen, will help shorten the asset cash-to-cash cycle and make your job easier -- we rarely have significant cash sales, as you've probably learned in the past few months.

To figure out how the assets and liabilities work together on this, you'll need to have some numbers in front of you. In particular, you'll want to know what our average daily sales and cost of goods sold are, and what our average purchases are. Finally, it would be useful to know our average daily operating expenses, too.

Once you have all of that stuff, convert the balance sheet into its daily equivalent. For example: part of the asset cash-to-cash cycle is the daily level of cash on hand. You can find this by dividing the cash amount on the balance sheet by the average daily sales figure to get "days cash." Accounts receivable is also directly related to our sales figures, but when looking at average inventory be sure to consider our daily COGS instead. On the other side of the balance sheet, payables are closely related to average daily purchases and accruals are related to operating expenses.

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Downloaded by Kelly Weaver on 1/22/2016. Park University, Ronal Lentz, Spring 1 2016

138 Cases in Financial Management

The asset cash-to-cash cycle is the combination of the "days cash," the similar measure for accounts receivable, and the inventory "days". This is roughly how long it takes us to convert a sale into cash, on average. For the liabilities, we look at "days payable" and "days accruals" as mentioned. These two numbers tell us how much we rely upon suppliers and employees for credit, and added together give us the number of days in the liability cash-to-cash cycle.

The difference between the total days in the asset cycle and the total days in the liability cycle is the number of days' worth of financing we'll need during the period. When used with our daily COGS number, it can tell us how much bank financing we might need during that time. If nothing else, it provides a rough estimate for using when we plan for a new year, and it helps us evaluate the rest of our working capital.

REQUIRED

1. Using the information in Exhibits 1 and 2, calculate McGhee's average daily sales, average daily cost of goods sold, average daily purchases, and average operating expenses. How much control does the firm have over each of these items?

2. Convert the asset portion of the firm's balance sheet in Exhibit I into its daily equivalent. How many days does the firm have in its asset "cash-to-cash" cycle?

3. Convert the short-term liabilities on the balance sheet into their daily equivalents. How many days are in McGhee's liability "cash-to-cash" cycle?

4. Using your answers from 2 and 3, above, determine the number of days that the firm may need to finance itself during the cash-to-cash cycle. How can this number be used to determine the amount of external financing necessary?

5. What types of external funding sources are appropriate for supporting a working capital deficit of the type that is described in Mr. McGhee's memo? Why are some sources more appropriate than others?